INTRODUCTION
The HKVCA sets forth our Response Paper below in relation to the Consultation Paper by the Financial Services and the Treasury Bureau ("FST Bureau") in January 2004. The HKVCA is keenly interested in this subject as we have supported the growth of the industry since our establishment in 1987 and now represents over 100 members managing in excess of US$50 billion in capital for venture capital and private equity investment in the Asia Pacific Region. A large proportion of this capital is being managed in the form of offshore funds with investments focused on small and medium sized enterprises ("SMEs") in Hong Kong, the Greater China Region and other investment destinations within the Asia Pacific region. Taxation matters relating to these offshore funds are therefore subject of significant relevance to our industry.
GENERAL COMMENTS
Generally, venture capital / private equity funds have the following characteristics:
(a) they have an intended limited life unless they are actively traded on a recognized stock exchange;
(b) they do not continuously raise capital during the life of the fund as investment is made from calling on capital committed by their investors;
(c) they are not required to redeem investors' interests upon their requests;
(d) unless actively traded on a recognized stock exchange, they must have a defined operating strategy to return the proceeds of divestments to investors;
(e) they do not routinely acquire listed securities or derivatives as the focus of their investment strategy.
The investment strategy of venture capital / private equity funds is characterized by the deployment of equity capital targeting investments for financial returns arising out of long-term capital appreciation. Most of the targeted investee companies are unlisted SMEs, a sector that generally has limited access to bank and capital markets financing. Capital provided by venture capital / private equity funds is used for business expansion (including capital expenditure, working capital and strategic acquisition), management buyout and re-capitalization. Exits from investments is through a listing of the shares of the investee company or strategic sale, and to a lesser extent, through structured sale such as the buyback of the fund's equity interest by the investee company or its other shareholders. Therefore, venture capital / private equity funds provide a vital source of growth capital for the economies these funds invest in. In addition, during the investment holding period, venture capital / private equity fund managers add value to investee companies through instilling corporate governance, providing advice on financial, strategic and operational matters, as well as strengthening management teams.
The profits generated on such equity investments are, therefore, capital in nature and, as such, are not subject to profits tax in Hong Kong, irrespective of where the fund sources its capital, either from Hong Kong or non-Hong Kong residents or investors.
While we do recognize and appreciate the current proposed amendments to the Inland Revenue Ordinance ("IRO") to exempt offshore funds in general from profits tax, we note that the proposed amendments should have limited applicability to funds operating in the venture capital and private equity industry, as profits or loss in our business are capital in nature and hence outside the ambit of Hong Kong profits tax.
For reference, in the May 26, 1987 statement between the U.K. Inland Revenue and the British Venture Capital Association on the use of limited partnerships as venture capital investment funds, it was made clear that the activity of acquiring and holding shares and securities as part of venture capital / private equity investment activity in itself is not a trading activity. This position is also confirmed in a ruling by the Special Commissioners for Income Tax.
Against this background, the proposed Consultation Paper on Exemption of Offshore Funds from Profits Tax would put the venture capital / private equity industry in a worse position than what we currently enjoy due to the onerous record keeping requirement and the residency test that is not feasible to implement. If the proposed legislation were implemented, this would certainly work against our efforts to attract offshore funds to Hong Kong and would significantly affect Hong Kong's ability to compete with other countries in the Asia Pacific region.
PROPOSAL
Given that venture capital / private equity investments are long-term and capital in nature, the HKVCA seeks confirmation of its current non-tax position by way of a written exemption of all venture capital / private equity funds from Hong Kong profits tax without being subject to the proposed residency test and the related record-keeping requirement. This proposed blanket exemption for the industry would also place Hong Kong more in line with the tax treatment of the venture capital / private equity funds in other major financial centres of the world such as the U.K.
COMMENTS ON PROPOSED LEGISLATION:
Without prejudice to our view of our non-Hong Kong tax position, the HKVCA has considered the proposed legislation, and is of the view that the proposed legislation is not suitable and not in the best interests for promoting venture capital / private equity investment in Hong Kong.
1. The 80% Residency Threshold
The 80% non-resident threshold is considered inappropriate:
(i) it is common in the venture capital / private equity industry that there is anchor investor in the fund that accounts for more than 20% of the total capital commitment. The 80% non-resident threshold would discriminate against Hong Kong residents from being the anchor investor in offshore venture capital / private equity funds as they may subject the whole fund to a less favorable tax position;
(ii) it is also common that the parent or associated company of the fund manager based in Hong Kong is the anchor investor and accounts for over 20% of the capital commitment of a genuine offshore venture capital / private equity fund that also includes third party investors;
(iii) often start-up funds may have seed funds provided by the Hong Kong based fund manager and a small number of other investors in order to create a track record for raising a larger fund from other outside investors.
More important, regardless of what the threshold level is, there are practical difficulties in implementing the residency test, including:
(a) many of the venture capital / private equity fund investors are multinationals investing from their corporate pension funds whose beneficiaries are the employees. These multinationals may also have subsidiaries / affiliates that operate in Hong Kong. It would be unreasonable to deem such multinationals as resident investors when their beneficial interests in the fund belong to the employees outside of Hong Kong rather than the Hong Kong subsidiaries / affiliates;
(b) an important source of capital for venture capital / private equity funds is overseas government and corporate pension funds and insurance companies and it is impossible to trace each of the ultimate beneficiaries of such capital;
(c) the fund’s investors may also include overseas listed companies whose shareholding structure is fragmented and whose shareholders list changes on a daily basis;
(d) another source of capital for venture capital / private equity funds is overseas foundations and trusts whose deed provides that the distribution of profits to the beneficiaries is at the discretion of the trustee with the beneficiaries not having any knowledge of their respective entitlement / interest in the fund;
(e) fund-of-funds whose investors would be another fund or layers of funds that invest in venture capital / private equity funds would have difficulty in identifying the ultimate investors.
2. Round Tripping of Hong Kong Residents
In the case of genuine venture capital / private equity investment, whether such investment is made by Hong Kong residents or foreign investors through an offshore fund, the investment is long-term and capital in nature and would, therefore, be outside the ambit of Hong Kong profits tax. Therefore, even if Hong Kong residents do invest through offshore funds, given the nature of venture capital / private equity investment, in practice, there is no real loss of tax revenue for the Hong Kong Inland Revenue Department ("IRD").
In addition, in the venture capital / private equity industry, it is common that fund managers based in Hong Kong operate independently with full investment discretion and are compensated on terms that are arms-length even though such fund managers
could be managing funds contributed entirely or partially by their associated companies in Hong Kong or overseas. Such Hong Kong based “captive” fund managers would still be acting independently vis-a-vis associated and unassociated investors alike.
3. Proposed Record-Keeping Requirement
We believe that the proposed record-keeping requirement is onerous for the non-resident investors in offshore funds as well as for the fund managers:
(i) it is not feasible to expect non-resident investors from different countries to be familiar with all the requirements laid down in section 20AB of the IRO in order to determine whether they are non-residents, and also be in a position to determine whether a change in their circumstances would affect the exemption granted. It is likely that non-resident investors would require engaging Hong Kong tax counsel to assist in filling out the residency form. Such record-keeping requirement in order to fulfill the residency test is costly and onerous and would deter many foreign investors from investing in offshore funds that invest in Hong Kong;
(ii) for reasons stated in Section 1 above, there are practical difficulties in looking through and determining who the beneficiaries of the fund are;
(iii) if the onus of accurate record-keeping is on the fund manager / fund administrator, it would create undue burden on the fund management industry;
(iv) most important, as discussed above, given the practical difficulties in implementing the residency test and the capital nature of venture capital / private equity investment that renders the concern of round tripping by Hong Kong residents a non-issue, the proposed record-keeping requirement on the residency of the funds’ investors is irrelevant.
CONCLUSION
The venture capital / private equity industry provides an important source of growth capital for SMEs. Due to the long-term and capital nature of venture capital / private equity investment, the profits and loss of our business activity is outside the ambit of Hong Kong profits tax. This also applies to Hong Kong residents investing through offshore funds. Therefore, round tripping by Hong Kong residents should not be a concern and the anti-avoidance provisions in the proposed legislation would not result in additional tax revenue for the IRD from profits tax. The proposed legislation as set out in the consultation paper would only put the venture capital / private equity industry in a worse position than we currently enjoy due to the onerous record-keeping requirement and the practical difficulties in implementing the residency test. It would also undermine our efforts to attract offshore funds to Hong Kong and to develop its potential as the pre-eminent centre for venture capital and private equity in Asia.
Therefore, on behalf of the venture capital / private equity industry in Hong Kong, the HKVCA seeks clarification by way of written exemption of all venture capital / private equity funds from Hong Kong profits tax without being subject to the proposed residency test and the related record-keeping requirement. This blanket exemption would place Hong Kong on par with major financial centres of the world such as the U.K. in terms of tax treatment of the venture capital / private equity funds.
Lastly, the HKVCA appreciates the FST Bureau’s efforts to work towards an early introduction of the legislative amendments to the IRO to exempt offshore funds from Hong Kong profits tax, as stated in the Financial Secretary’s 2003-04 Budget announcement. Since this is an important piece of legislative amendment to put through for the fund management industry as a whole, and since there are many practical and detailed issues to consider, we hope that the consultation period could be extended in order that we could be given the opportunity to discuss more fully the application of the proposed legislation to the venture capital / private equity industry.
5